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Catalysts Elude Bank Stocks

It could be a rough year as the yield curve stays flat and M&A lean.

The risk-reward calculus for bank stock investors is turning negative.

Fourth-quarter earnings, which banks will start to report next week, are not likely to generate much heat. The expectation is for bank profits to rise anywhere from 8% to 10% compared to a year ago.

That's not bad. But it's nothing for investors to get too excited about, either.

"I don't think anyone is expecting great things,'' says Michael Stead, manager of River Aire Investment, a hedge fund that invests mainly in financial stocks. "It's looking like a ho-hum quarter.''

Bank stocks would appear to have little near-term momentum, what with the Philadelphia KBW Bank Index up nearly 10% since the end of the third quarter. Much of the run-up has been fueled by the hope that the

Federal Reserve

will soon stop raising interest rates and anticipation of a revival in bank mergers.

However, don't be surprised if bank stocks give back some of those gains, especially if a number of bank earnings disappoint the next two weeks.

Meanwhile, the earnings outlook for 2006 is not much rosier than the quarter just ended. Analysts say a tricky interest rate environment coupled with the need by banks to begin bolstering their loan-loss reserves in an anticipation of darker days ahead should keep a lid on bank profits.

Thrifts and regional banks will continue to be hardest hit by the so-called inversion of the yield curve, which is likely to haunt the bond market this year. That's the unusual phenomena, which occurred earlier this month, in which the yield on short-term Treasury notes is actually higher than the yield on longer-term government bonds.

The inversion of the yield curve makes it particularly difficult for banks, which generate much of their profits by investing customer deposits into interest-bearing securities, such as mortgage-backed bonds. The flattening yield curve has all but wiped out the ability of banks to borrow on the cheap and reinvest the money in longer-term mortgage-backed securities.

A case in point is Tuesday's earnings warning from

TD Banknorth


. The Portland, Maine-based company said fourth-quarter earnings will come in 2 cents shy of the current consensus estimate of 64 cents a share because of the negative impact of the flattening yield curve on its deposit and investment operation. Look for other banks that are heavily invested in mortgage-backed securities to sound a similar cautionary note in the coming weeks.

Maybe the best thing bank investors have to look forward to this year is an expected revival in industry consolidation, an event that often sparks speculation in the sector. Most experts are looking for a surge in bank deals in 2006, especially because last year was a relatively quiet one with few headline-grabbing combinations.

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"There should be a lot of consolidation, especially with smaller banks being acquired,'' says Timothy Ghriskey, a money manager and chief investment officer of Solaris Asset Management in Bedford Hills, N.Y.

To be sure, no one is expecting a repeat of 2004, which began with the announcement of one of the biggest bank mergers ever:

J.P. Morgan Chase's

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$59 billion acquisition of Bank One. By year's end there were 245 announced bank deals in the US worth more than $113 billion. The only other year involving bigger deals was 1998, in which bank mergers totaled $250 billion, according to Thomson Financial.

By comparison, there were 188 mergers last year for a total value of $61 billion.

But with the U.S. banking market still much less consolidated than Europe's, analysts say the environment is ripe for a new round of deals. Mergers also are a way for big banks to drive revenue growth, which could come under pressure if demand for consumer borrowing slows this year as expected.

David Hendler, an analyst with CreditSights, expects


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Wells Fargo

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and J.P. Morgan all to be on the prowl this year. He says big banks will be looking for deals that bolster their national retail banking reach. Some potential targets, he says, are

Washington Mutual

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PNC Financial

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Fifth Third

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Huntington Bancshares

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Just about the only big bank that investors can count on standing pat this year is

Bank of America

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. Over the past two years, the nation's second-largest lender has pulled off two of the biggest deals: the acquisition of FleetBoston Financal and credit-card giant MBNA.

But investors trying to play the merger game may find slim rewards in betting on individual acquisition targets.

"In the past, a target bank has enjoyed an acquisition premium. However, given that the stock prices of potential targets have already 'priced in' potential takeover premiums, we think the upside potential of these targets is diminished,'' says Hendler, in a recent research report analyzing banking industry trends.

So what's a merger speculator to do?

One option is to buy shares in the

Merrill Lynch's Regional Bank HOLDR


, an exchange-traded fund that tracks the performance of about two dozen bank stocks, including some oft-mentioned acquisition targets. This ETF effectively serves as a basket of regional bank stocks. An investor who purchases this security can hope to get upside from merger speculation that spreads across the sector.

A better bet, say traders like Ghriskey, is to look for small banks, ones with market caps under $1 billion, that lack a big analyst following.

But the trouble is that identifying smaller, off-the-radar banks is not easy. And Ghriskey says an investor may have to "sit on them a while'' to gain any merger benefit.

Either way, it looks like the easy money is gone out of the banking sector this year.